Sunday, July 25, 2010

There has been a lot of talk recently about the growing income inequality in the United States. Personally, and I could not care less about what others have as long as people are capable of living a decent life. however, for some reason this seems to bother a lot of people. In addition, people like to speculate as to why income inequality has increase so much over the past 30 years. While this is a complicated subject with a lot of contributing factors, it seems to me that we seem to miss the most obvious and, quite likely, the most important factor. Over the past 40 to 30 years the top marginal tax rate has decreased significantly from approximately 90% to 35%. Does it surprise anyone that over the same period the amount of money that the top 1% of people make has increased as the amount that they are taxed decreased? Is this not basic economics? If you tax something, you get less of it and if you tax something less you get more of it.

If all we want is to significantly reduce income inequality, all we would need to do is raise the marginal tax rate to 100% for some given income level, such as 1 million dollars. We could set up a system where the dollar amount does not increase with inflation, or only increases at half the rate, which would slowly lead to converging income levels and reduce income inequality. However, I think that this would have some serious costs. In fact, if you think that this would have any negative effect on economic output and performance, you agree, at least in part, that supply side economics does have some merit.

In a previous post I talked about why I do not find talk about natural resource constraints on economic growth. Put bluntly, I feel that there is absolutely no reason as to why we cannot continue to expand the world economy indefinitely. A lot of times that I bring this up, people attempt to refute this assertion by bringing up the point that the Earth is finite, with a finite amount of resources. I find this argument weak and I think that people that make this argument tend to only examine one portion of the equation that determines economic growth. For example, I have put together a very simple model of how the world works and the relationship of resources to economic growth. Here it is: Yt = N * At * Tt. Where Yt is the economic output of the world economy at time t. N is a constant that represents the amount of natural resources on this planet. At represents the share of the natural resources that we are technologically capable of extracting and can use. Tt is our technological ability to change the natural resources into something else.

People who say that we cannot continue to grow our economy point out that N is constant and once you reach a point where At = 1, Yt will not be able to increase. However, this argument fails, because it does not take into consideration Tt. Why does this matter? Lets look at a couple of examples.

Two thousand years ago it would have been impossible to build a tractor to increase the agricultural output of your land. Even if you had the same amount of iron, copper and other natural resources, you still could not make those resources as productive as a tractor. Even if we held the amount of natural resources constant, transforming them into a tractor would make them significantly more productive and more valuable. Essentially, we have held N and At constant and increased Tt, which has increased Yt.

What about other resources, such as oil. We are currently using oil and turning it into other things, like CO2 through the use of internal combustion engines, which may be causing N to actually decrease over time. However, over time Tt has increased as well. We can now go farther and do more with a gallon of oil than we could have before. Lets say that we have used about half of the oil that is in the Earth. does this mean that we can only do half as much? Of course not. If over this time we doubled the efficiency of our oil use, we have essentially not changed the productive capacity of our resources. Essentially, we have slightly decreased N, but Yt was able to increase, due to Tt increasing as well.

The model presented here is quite basic. If fails to take into consideration that each of the variables may be dependent on each other as well. For example, it is quite possible that by using the resources we are causing Tt to increase at a faster rate than it would have otherwise. If this is the case, the use of resources helps us to develop new ways of conserving the resource as well. The only question to our ability to continue to grow our economy forever would be: can Tt continue to increase? At this point, I only see evidence that Tt is actually increasing faster now than it has in the past, and I don't see any reason why it cannot continue to increase for any significant amount of time.